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Gross Shocks Conventional Wisdom

Bill Gross told investors this week to Beware the Ides of March, or the Ides of any month in 2015 for that matter. When the year is done, there will be minus signs in front of returns for many asset classes. The good times are over. Gross is the legendary bond fund manager who left the company he founded, PIMCO, for a job as a portfolio manager at Janus Global Unconstrained Bond Fund, so most people pay attention when he writes. The prediction came inside the January Investment Outlook for investors. But for the mainstream financial media, he might as well have expelled foul smelling gas at a crowded party. The media quickly pointed out how contrarian his forecast is. For example, the Bloomberg reporter wrote: Gross is putting himself way out on a limb: Not one of Wall Street’s professional forecasters predict the S&P 500 will drop in 2015. Their average estimate calls for an 8.1 percent rise. And while the global economy looks weak, the U.S. has been heating up, with GDP up 5 percent in the third quarter. Of course, he forgets that mainstream financial experts and economics have failed to see every recession for the past century, especially the latest. They have failed because their business cycle theory asserts that recessions and the stock market collapses that precede them are random events. In other words, @#$% happens! So while insisting that business cycles are random events and by definition unpredictable, they continue to insist they can predict them! Gross makes one mistake that shows the bad influence behavioral finance has inflicted on him. He wrote, Manias can outlast any forecaster because they are driven not only by rational inputs, but by irrational human expressions of fear and greed. Stock and bond market “bubbles” are not manias; humans are not irrational with their money and the current market levels don’t illustrate greed or fear. As my forecasts show, the stock market reflects historically high profits plus greater tolerance for risk by investors. And the bond market is responding rationally to the Fed’s loose monetary policy. Fortunately, Gross doesn’t follow mainstream economics. His rationale comes from the “debt super cycle.” Gross attributes the theory to the research and investment advisory firm Bank Credit Analyst, but the cycle has been a major theme of the Bank for International Settlements for years. You can find a good intro in Claudio Borio’s The financial cycle and macro economics: What have we learnt? In short, the theory says that debt increases when central banks pump money into the economy through artificially low interest rates and open market operations, that is, buying bonds, also known as quantitative easing. Much of the debt increases the value of capital that has been used as collateral on loans and makes further borrowing on the same collateral possible. Credit continues to expand, asset prices rise and GDP increases as part of the expansion phase until debt service burdens become too great for businesses or households to bear, causing them to cut back on spending. As a result, asset prices fall and banks demand more collateral for outstanding loans. Some companies default and the financial system spirals downward, taking the economy with it. The latest debt super cycle extended almost 20 years peak-to-peak, from about 1989 to 2007. Business cycles last up to 8 years, but when a recession coincides with a peak in the debt cycle, it’s much more severe. There is a lot of truth in the debt super cycle theory. But it doesn’t explain why debt service becomes unbearable. After all, if asset prices are increasing and the economy is growing, debt service should become easier. The debt theory needs the Austrian business-cycle theory to make it whole. Debt service becomes a burden when sales fall in the capital goods sector because sales are soaring in the consumer goods sector. This is Hayek’s Ricardo Effect kicking in. However, the debt theory helps flesh out some of the financial aspects of the ABCT. So what does Gross advise investors to do? He recommends buying Treasuries and high quality corporate bonds. He cautions that rising interest rates could hurt such investments, but if the debt cycle theory is correct, that won’t happen in 2015. Only contrarians like Gross make money when the market morphs from a bull to a bear.

Health Care ETF: XLV No. 2 Select Sector SPDR In 2014

Summary The Health Care exchange-traded fund finished second by return among the nine Select Sector SPDRs in 2014. As it did so, the ETF posted the second best annual percentage gain in its 16-year history. Seasonality analysis indicates the good times may continue rolling in the first quarter. The Health Care Select Sector SPDR ETF (NYSEARCA: XLV ) was ranked No. 2 in 2014 by return among the Select Sector SPDRs that carve the S&P 500 into nine slices. On an adjusted closing daily share price basis, XLV ballooned to $68.38 from $54.64, a swelling of $13.74, or 25.15 percent. As a result, it behaved better than its parent proxy SPDR S&P 500 ETF (NYSEARCA: SPY ) by 11.68 percentage points and worse than its sibling Utilities Select Sector SPDR ETF (NYSEARCA: XLU ) by -3.59 points. (XLV closed at $70.84 Thursday.) XLV ranked No. 4 among the sector SPDRs in the fourth quarter, when it led SPY by 2.50 percentage points and lagged XLU, the Consumer Discretionary Select Sector SPDR ETF (NYSEARCA: XLY ) and the Consumer Staples Select Sector SPDR ETF (NYSEARCA: XLP ) by -5.79, -1.25 and -0.86 points, in that order. However, XLV ranked No. 8 among the sector SPDRs in December, when it performed better than the Technology Select Sector SPDR ETF (NYSEARCA: XLK ) by 0.78 percentage point and worse than SPY by 1.15 points. Overall, XLV posted the second best annual percentage return in its 16-year history: Its record was set in 2013, when it astounded by skyrocketing 41.41 percent. Figure 1: XLV Monthly Change, 2014 Vs. 1999-2013 Mean (click to enlarge) Source: This J.J.’s Risky Business chart is based on analyses of adjusted closing monthly share prices at Yahoo Finance . XLV behaved a lot better in 2014 than it did during its initial 15 full years of existence based on the monthly means calculated by employing data associated with that historical time frame (Figure 1). The same data set shows the average year’s weakest quarter was the third, with a relatively large negative return, and its strongest quarter was the fourth, with an absolutely large positive return. Inconsistent with this pattern, the ETF had excellent gains each and every quarter last year. Figure 2: XLV Monthly Change, 2014 Versus 1999-2013 Median (click to enlarge) Source: This J.J.’s Risky Business chart is based on analyses of adjusted closing monthly share prices at Yahoo Finance. XLV also performed a lot better in 2014 than it did during its initial 15 full years of existence based on the monthly medians calculated by using data associated with that historical time frame (Figure 2). The same data set shows the average year’s weakest quarter was the third, with a relatively small negative return, and its strongest quarter was the fourth, with an absolutely large positive return. Meanwhile, there is a historical statistical tendency for the ETF to do well in Q1. Figure 3: XLV’s Top 10 Holdings and P/E-G Ratios, Jan. 8 (click to enlarge) Note: The XLV holding-weight-by-percentage scale is on the left (green), and the company price/earnings-to-growth ratio scale is on the right (red). Source: This J.J.’s Risky Business chart is based on data at the XLV microsite and FinViz.com (both current as of Jan. 8). The health-care sector in general and XLV in particular progressed from a sweet spot to a sweeter spot to an even sweeter spot between June 2012 and October 2014. As discussed elsewhere previously, it appears XLV’s share price was driven by these key factors: Obamacare: The Affordable Care Act’s constitutionality was established in the landmark National Federation of Independent Business v. Sebelius decision handed down by the U.S. Supreme Court June 28, 2012, as documented by the court. Quantitative Easing: The Federal Open Market Committee announced the launch of the U.S. Federal Reserve’s latest QE program Sept. 13 the same year, as noted in “SPY, MDY And IJR At The Fed’s QE3+ Market Top.” Sector Rotation: A signal for such rotation, the beginning of the end of the Fed’s QE3+ program was announced by the FOMC Dec. 18, 2012, as pointed out in “Building A Martin Zweig-Like Fed Indicator Integrating Innovations Of The 21st Century.” The FOMC announced the completion of asset purchases under the QE3+ program last Oct. 29, so QE will not be a key driver of XLV in the first quarter. However, the other two factors may continue to be in play. A big risk to XLV and its constituent companies is the Obamacare-related King v. Burwell case currently before the U.S. Supreme Court. The justices most likely will hear arguments in March, according to the SCOTUSblog . They are expected to deliver a decision by July, with the ruling constituting a binary event for the Health Care ETF, as follows: If the decision is favorable to Obamacare, then its effect on XLV’s share price may be relatively small and short lasting. One analog might be the move in SPY between Dec. 17 and Dec. 29, associated with the FOMC statement on the former date. If the ruling is unfavorable to Obamacare, then its impact on XLV’s share price may be absolutely large and long lasting. One analog might be the move in the Energy Select Sector SPDR ETF (NYSEARCA: XLE ) from June 20 to the present, associated with the crude oil price attaining either a long term or a cycle peak on the former date. Incredibly, the health-care sector’s and XLV’s awesome performances the past couple of years have not resulted in too many absurd valuations, as indicated by the above chart (Figure 3) and numbers reported by S&P Senior Index Analyst Howard Silverblatt, Dec. 31. At that time, Silverblatt indicated the P/E-G ratio of the S&P 500 healthcare sector was 1.38, which may look a little dear to growth and value folks like me but a lot cheap to normal people. Disclaimer: The opinions expressed herein by the author do not constitute an investment recommendation, and they are unsuitable for employment in the making of investment decisions. The opinions expressed herein address only certain aspects of potential investment in any securities and cannot substitute for comprehensive investment analysis. The opinions expressed herein are based on an incomplete set of information, illustrative in nature, and limited in scope. In addition, the opinions expressed herein reflect the author’s best judgment as of the date of publication, and they are subject to change without notice.

Closing The KYN-AMLP Pairs Trade

Six months ago, I suggested that investors buy Kayne Anderson MLP Investment Company due to its unusually large deviation from its historical premium/discount value. The KYN-AMLP pairs trade was in positive territory for nearly all of the trade, and actually reached +6% three months into the trade. As a hedged strategy, investors in the KYN-AMLP trade were insulated from fluctuations in the price of oil, but could still benefit from mean reversion in CEF premium/discount values. Six months ago, I made the case to buy Kayne Anderson MLP Investment (NYSE: KYN ) due to its abnormally large deviation from its historical premium/discount value. KYN’s strong outperformance over its benchmark, the Alerian MLP ETF (NYSEARCA: AMLP ), allowed the fund to maintain an average premium of 9% over the last five years. However, its lackluster price performance in early 2014 had caused the KYN to veer into discount territory, something that had not been seen since 2009. Given that KYN had actually outperformed AMLP on a year-to-date NAV basis at the time of the article, I reasoned that mean reversion would cause KYN to outperform its benchmark in the months ahead. Therefore, I suggested for investors to buy KYN (and to sell AMLP). Six months later, the KYN:AMLP ratio has barely changed. However, note that this trade was in positive territory for nearly all of the six months. Moreover, about 3 months into the trade, KYN had actually outperformed AMLP by nearly 6%. (click to enlarge) Part of this reason was due to the reversion of KYN’s discount to its historical mean. In other words, investors in KYN were benefiting simply through premium expansion rather than due to gains or losses of the underlying portfolio. The following chart shows the premium/discount of KYN in 2014 (graph reconstructed from data supplied by Kayne Anderson ). (click to enlarge) Therefore, an investor in the KYN:AMLP pair might have thought to harvest their profits in KYN as its premium reverted higher. While 6% in three months isn’t anything spectacular, keep in mind that this is was a pairs trade, meaning that it is essentially a market neutral strategy that limits downside risk. Moreover, it works out to be annualized profit of 24%, which is similar to the ETW-EXG pairs trade I presented previously. Obviously, both KYN and AMLP have done rather poorly over the past several months as the price of oil tanked. I won’t hide the fact that an investor who bought KYN at the time of publication of the article would be down around 5%. Yet, the investor who swapped his existing shares of AMLP for KYN would have done better than the investor who simply held on to AMLP. (Note that I wouldn’t recommend shorting AMLP outright due to the costs involved). KYN Total Return Price data by YCharts As I have described many times in previous articles, mean reversion of premium/discount values in CEFs is a way to add an extra layer of performance on top of your CEF holdings. Academic research supporting the notion of mean reversion in CEFs is abundant (e.g. here and here ).